We haven’t posted an update since we wrote our Economic Update and Investment Forecast for 2005. That paper was written in mid to late December 2004 and the good news for our clients is that we still believe the major themes presented in that paper are going to play out in our favor during 2005.

Some of those themes were as follows:

1. Gold will rally, but not without the possibility of a significant drop in price first.

We’ve had the drop in price and are now starting the rally. Gold tends to move in the opposite direction of the dollar. The dollar experienced an oversold rally during the last couple of months and had been moving upward. That movement seems to be about over and a reversal seems to be at hand. We remain strong believers that the path of the dollar is downward and the path of gold if upward.

2. The dollar will continue to fall relative to other major currencies, but not without an upward correction first.

We’ve had the correction and now the dollar is back to 1.30 Euros. We believe our theme regarding the falling dollar to be intact. And, therefore gold has started to rally back. The XAU (Philadelphia Gold and Silver Index) has recently rallied from approximately 87 to 96.

We have also been buyers of foreign bond funds that are not denominated in dollars. This is a direct bet on the falling dollar, and a way to be paid interest while it falls.

3. Oil prices should stabilize, if not drop, into 2005.

They dropped for a very short time, and are now back up to levels similar to those of late 2004. If we could update this theme for you, we would have to say that oil prices may stabilize or drop going into the spring season. Spring is often a weak season for energy pricing and energy related stocks. But we’d also warn you not to get used to lower prices if that happens.

It is certainly conceivable that oil prices could drop below $40 again. But longer term we see higher prices in oil and gas. $60.00 per barrel is not out of the question by 2006. America has no friends in OPEC.

We would be a buyer of energy related stocks on any weakness.

4. We said that we saw the Japanese economy gaining traction and we still believe that—although their economy shrank again in the 4th quarter of 2004.

The Japanese are working through the end of their 15-16 year recession/depression. The Nikkei 225 continues to have difficulty gaining traction. But just as Japan’s collapse and recession related malaise took a long time to play out, so will the recovery. The recovery is in the very early stages and we believe this is a good time for investors to be “buying” Japan.

5. We mentioned that there might be a “real estate bubble” but that we didn’t see home prices collapsing. They haven’t and aren’t likely too in the immediate future.

We also discussed that prices might stabilize and that seems to be true in our local market. The Realtors tell us that the homes selling for $2 million or more are “dead”. But then, ten years ago who would have believed that there would be so many $2 million homes in the Napa Valley.

Nationally real estate sales have not trended downward and neither have prices.

Resort area prices are still rising.

Some localized pressure on prices exists in markets that have moved “too far, too fast”. Las Vegas and the Bay Area come to mind.

New home construction and sales are still surprisingly strong. Just drive around American Canyon if you question that conclusion.

The demand for residential real estate is intact. The only thing that could get in the way is rising interest rates. If you have a variable rate mortgage—CONVERT IT TO A FIXED RATE NOW!!!!!!!!!

6. We really equivocated on the U.S. stock market in 2005. We didn’t say whether we thought it would go up or down in 2005. We simply said “We have gone from “overvalued” to “significantly overvalued” to “not exactly cheap” over the course of 7 years.

We also observed that “If the U.S. stock market is over valued, does that imply there may be investment alternatives that offer greater opportunity for consistent returns? We believe that to be true. Many of our client’s portfolios are currently more diversified than they have ever been in the past. The days of portfolios being comprised only of U.S. stocks, bonds, and cash, like those that thrived in the 1990’s, have been over for quite some time. K&A clients now find themselves diversified into foreign stocks, commodities, precious metals, currencies, and real estate.”

We’ll the U.S. stock market has been flat to down all year so far, and we would be surprised if it made significant gains in 2005. Most professional investors are quite sanguine at the moment no one seems to expect the stock market to move upward or downward very much. So if there is a surprise, the odds are that it would go against the crowd and therefore the market would surprise us on the upside or the downside.

One big factor that is influencing stocks this year is all the merger and acquisition activity. In 1998, when there were 7800 mergers, over $1.6 trillion in M&A activity was unleashed. 2005 should eclipse that record.

While no one knows for sure which companies will be purchased there are several company’s on the K&A stock list that are often mentioned as prime takeover candidates.

7. We also said that “China may stumble in 2005, but if it does it should be a very temporary stumble. Investing in China today is like investing in the U.S. in 1880. There may be wild swings up and down but we want to be dollar cost averaging into their equity markets for the next 5 to 10 years.”

So far Chinese equities have really not gone up or down significantly in 2005, but we still love China as a long term investment theme. We are buyers of China. Ignore China at your own risk.

There were lots of other “fearless forecasts” and editorializing in that report. After all it was 21 pages long. But maybe the most important consideration for investors this year is the action in interest rates and therefore the bond market.

8. WE SAID…. Interest rates should rise in the U.S. but not enough to cut off economic and market growth.” That was our statement. We also said that the consensus forecast for the 10 year Treasury yield was 5.10 percent by the end of the year.

To put that in perspective for you the 10 Year Treasury yield was about 4.10 percent when we wrote the report.

The truth is that while 5.10 percent was the consensus forecast at the time, and we were stating that we thought the most likely direction for interest rates was upward—we weren’t really 100 percent committed to that forecast.

We adopted UCLA’s forecast of GDP growth for the year of 2.8 percent. That is way below consensus of most U.S. economists. We also said that by 2006 we could be back in a recession. That would actually imply lower interest rates in the future, not higher. So we have really been equivocating on interest rates, and therefore on whether or not it is a good investment opportunity to own long term bonds.

We believe that there is now a little more clarity on this issue and would stack the odds more in favor of long term interest rates rising to at least that consensus of 5.10 percent on the 10 year Treasury.

If that actually happens a 10 year treasury bonds yielding 4.10 percent would drop approximately 8.1 percent in value.

Did you get that? A one percent increase in interest rates would cause the market value of a bond that you owned to drop by 8.1 percent. OUCH!

The market value of bonds with maturities longer than 10 years would drop even more. A 30 year treasury would drop almost 18 percent in value.

So are interest rates going to continue to rise? We are more confident that will be the case. After all, they are rising. Check out this chart.

As you can see, the yield on the 10 year Treasury bond bottomed out at 3.074% in May of 2003. They have been in a rising channel ever since. The problem is that the channel is not clean. If you look at the support line that has been drawn on the chart you can see that we are currently experiencing what the technicians like to call “congestion” in the 4.00% to 4.25 range. We had a close at 4.26% on Friday.

Put the current rise in rates together with inflation that is clearly rising, a dollar that is still trending downward, federal and trade deficits as far as the eye can see, and we think the odds are growing that long term rates could move significantly higher.

Therefore we are going to start selling any individual bonds held in our investors’ portfolios that have maturities of 8 years or more. If interest rates do continue moving higher it is these longer maturity bonds that will take the biggest hit in market valuation. The good news for our investors is that the overwhelming majority of bonds that we will be selling are still selling at a premium to face value. That is because they were either bought years ago, when interest rates were higher; or they were bought in May-July 2004, another period of higher rates.

Frankly most of our clients are not impacted by this decision. The overwhelming majority of our clients who had positions in the U.S. bond market had them through mutual funds that owned bonds. The overwhelming majority of those shares were sold off between February and April 2004. In hindsight that is starting to look like a pretty good decision.

We’ll continue to keep you posted on trends in the bond market throughout the year.

Regards,

Paul Krsek
For K&A Asset Management, LLC

Disclosure and Disclaimer (updated 11/28/05):

E-lluminations and Illumination are proprietary newsletters written for clients, friends, and affiliates of K&A Asset Management, LLC (K&A).

Paul Krsek is the sole author of E-lluminations. While the views and representations found in the newsletter generally reflect the attitudes and opinions of the K&A Asset Management “team”, Krsek writes without editing and therefore is solely responsible for the content and opinions contained in E-lluminations.

Illumination is normally published as a joint effort by Robert Andreae and Paul Krsek.

Neither E-lluminations nor Illumination represents the opinions of Fidelity, Fidelity Institutional Brokerage Group, NFS or any Fidelity affiliates. Neither Fidelity, Fidelity Institutional Brokerage Group, nor NFS has participated in the creation of E-lluminations or Illumination and they are not responsible for their contents or distribution.

E-lluminations and Illumination are written to provide general information to clients, friends, and affiliates. They are not to be taken as individual investment advice. No investment decisions should be made based on the opinions or information offered in E-lluminations and Illumination. 

K&A does not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change or modification without notice.

The investment portfolio models or management services mentioned in E-lluminations or Illumination may or may not be available in some states, and they may not be suitable for all types of investors.

The advisor representatives at K&A manage accounts with various histories and investment objectives. Various accounts may be managed differently from time to time, and by different individuals acting as investment advisor representatives.

Lead portfolio managers are assigned to make all trading decisions if an account is being managed according to a specific portfolio model. The Lead Managers assigned to various portfolio models are identified on our website at http://www.kaassets.com/choices.htm

Some accounts managed by K&A are managed individually and not subject to the discipline of a particular model portfolio. Individual advisor representatives assigned to an account have the authority to make decisions related to that account. K&A Asset Management, LLC, as an entity, does not manage investment accounts. Individual advisor representatives, or teams of advisor representatives manage accounts. Please refer to your K&A Asset Management agreement for specifics related to this disclosure and be sure that you understand who at K&A is actually managing your money.

The investment objectives of various accounts may be substantially different from one another. Therefore topics or investments mentioned in E-lluminations and Illumination may or may not apply to specific managed accounts.

Trades or adjustments to accounts mentioned in E-lluminations or Illumination may or may not happen in every account managed by advisor representatives at K&A. Advisor representatives are not responsible to manage every account similarly. Advisor representatives are responsible to manage accounts according to their understanding of the investment objectives, suitability and time frames of the owner of the account.

If you are not satisfied with the investment results in your account it is your responsibility to inform your advisor representative and to discuss possible changes that can be made to the account to accommodate and satisfy your needs.

The assets held in managed accounts at K&A Asset Management, LLC may include stocks, bonds, cash, commodities, foreign exchange or mutual funds, money market accounts or limited partnerships that represent the same. They are subject to market fluctuation and the potential for losses. The assets are not insured. The value and income produced by these investment products may fluctuate, so that an investor may get back less than they initially invested.

The advisor representatives at K&A Asset Management, LLC do not guarantee results.

Past performance should not be considered an indicator of potential future performance. If you do not consider yourself suitable, either emotionally or financially, to experience volatility and/or losses in financial markets, you should not invest.

This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy any securities or other instruments mentioned in it.

Sincerely,

Paul Krsek
Updated: November 28, 2005

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